‘Correlation’ rather than ‘contagion’

[EJ]

‘Correlation’ rather than ‘contagion’
February 28 2007 (Financial Times)

Why did so many world markets sell off on Tuesday? On the surface, there are similarities to the Asian crisis of 1997, which gave markets the word “contagion” – financial and currency crises spread from one country with weak economic fundamentals to another, until European and US markets also suffered.

This time, however, several analysts suggested that the cause was slightly different. Rather than contagion starting in China, where markets fell 9 per cent on Tuesday, they suggested that there was a correlated fall that involved many different assets that appeared over-valued and, therefore, unattractive for investors who had become more nervous about economic risks.

David Bowers, managing director of Absolute Strategy Research in London, said that correlation between asset classes was increasing. He drew a comparison be-tween investment in China and the “bubble” in tech stocks in 1999 and 2000. “China could grow at 10 per cent forever. But people forget that the consumers of their products are essentially cyclical. And they are, essentially, US consumers.

US demand has come in weaker than expected. Maybe the China story and the subprime story are linked,” he added. “The weakness in housing is going to cause real problems in the supply chain to the US consumer – and that could be US small-caps, or it could be in Asia. The saying these days is that the only thing that goes up when the market goes down is correlation.”

AntiSpin: Today speculation over yesterday's global market slide, which continued in Asian and European markets but not in the U.S., centered on the relationship between China's markets and the rest of the world. I speculated yesterday that Greenspan's unusual public speech Monday about a U.S. recession this year–a first for a standing or retired Chairman of the Fed–was intended to talk down (risk adjust) over-priced global markets by suggesting that a primary source of global demand–the U.S. consumer–may take a breather. The catch-word today is "correlation."

The FT reporter in the piece above confuses the asset correlation with global stock market correlation.

Positive asset correlation is the unusual circumstance of asset classes which have historically had a negative correlation, such as commodities and stocks, moving up and down together in price. You'd be hard pressed to find one asset class among stocks, bonds, real estate, precious metals, junk bonds, or private equity–to name a few–which have not move together in the same direction for the past few years. Recently real estate broke ranks, along with related securities, such as Mortgage Backed Securities (MBS), Collateralized Debt Obligations (CDO), and related credit derivatives (insurance against losses from default.)

Yesterday, for example, the stock markets fell around 4%. So did gold. Back when gold was a flight to safety asset, a major market correction sent at least some flight capital into gold. That may happen again, when the willingness of global central banks to inflate all currencies to avoid a global debt deflation is more widely understood. Only U.S. treasuries came out as the clear winner yesterday, the beneficiary of a rush to perceived safety–helps explain why only U.S. stock markets among global markets did not continue to decline today. (Either that, or the markets were taking back yesterday's 200 point ten minute technical loss.)

In the context of Ka-Poom Theory, here at iTulip, we call the post 2004 period of positive asset correlation the All Assets Up phase of the post 2001 global central bank reflation "Poom." Expect an equally unusual All Assets Down "Ka" process to follow at some point, as global credit markets contract, starting with the canary in the coal mine, the sub-prime segment of the U.S. housing market.

The market correction yesterday demonstrated positive asset correlation reversing prices, and also global market correlation. However, rather than correlated to global liquidity as are asset prices, global stock markets are correlated to U.S. consumer demand. Global stock market values are a function of return on risk–putting risk aside for now–return is a function of economic growth. Global markets reacted yesterday to the surprise Greenspan announcement that U.S. economic growth–the primary source of demand for the economies hosting the various bourses that fell–may go into reverse later this year. No standing or retired Fed chairman has ever made such a assertion in public before.

There is another key lesson we can take away from yesterday's market events. The fat cats of the global markets–the U.S., Europe, and Japan–have participated for 40 years in a global economic system which extracted surplus income from every other other country in the system, including China. Yesterday's global market correction was for the first time centered on China, rather than emanating from a small economy at the periphery of the system, as in the case of the Asian currency contagion episode of 1997/1998. Economic M.A.D. explains how the U.S. now relies for foreign investment, to fund trade and fiscal deficits, on a Chinese economy that runs on credit and corruption; China relies for demand for exports on a U.S. economy that runs on asset speculation, significantly financed by foreign investment. From now on, with each shuddering shift to a new global monetary system, this unstable dependency, in the context of a disintegrating, aging global monetary system, will become more apparent.

[miju]

Re: ‘Correlation’ rather than ‘contagion’

You have to add another word : "positive feedback". It is a phenomena in physics whereby you watch an increase in acceleration. This is a rare event. It happened yesterday when the Dow plunged in 2 minutes. On contagion or correlation :whatever the word you use we know that most of recent asset performance was supported by leverage and by Hedge funds which by historical irony are no more leaders in invesment but coincident players reinforcing the correlation among assets and by definition increasing the contagion. tHe hedge fund community has reached a very high level of "lemminging" (from lemmings) watching the neighbour's behaviour before acting and copying. On China : there is no economic relation between Shangai stock market and Wall street. Chinese bubble is a pure domestic bubble. Chinese loses money and lose power to consume, no problem they are not a major actor in imports worldwide. This is stupid contagion. However, the starting credit crunch in the US is far more important as is rises the risk premium on any assets (which by definition push down the price). That is real economic contagion.
best regards
Miju

[Ed]

Re: ‘Correlation’ rather than ‘contagion’

How about ‘inherent correlation’: price = value + air; and air is volatile stuff.

[akrowne]

Re: ‘Correlation’ rather than ‘contagion’

The analysis community is lacking a few basic tools that could really help make sense of the current situation.

Of glaring relevance here is some signals theory.

What appears to be going on here is that in the "high frequency band" (short term), all markets are correlated. Thus, as the stock markets crash, silver and gold crash (in fact even more precipitiously than the general market, judging by ETF shares).

But in the low frequency band (medium to long term, over the past 5-10 years), there has been an anticorrelation. The market has stagnated or fallen in inflation adjusted terms while precious metals have risen dramatically.

I would argue that markets will naturally behave independently in these two activity "bands". This is because traders and speculators will generally have short-term attention spans, dominating the short-term/high-frequency movements, while investors and long-term speculators control the long-term/low-frequency behavior.

When you throw "extreme credit" into the mix, the short-term band can decouple from the long-term, becoming positively correlated even while the long-term is negatively correlated. Enter today's hedge funds and other proprietary traders that behave just like them, who together probably make up at least 2/3rds of the volume of the market. These traders are highly-leveraged, subject to a severe principal-agent conflict, and borrow to gamble in everything indiscriminantly -- even (paradoxically) precious metals (via ETF shares). Thus when any de-leveraging occurs (credit crunch), all asset classes inflated by credit and especially the activities of these entities will correct sharply.

It happened last May, and it happened again yesterday, as I had been expecting and arguing (to all parties who would listen, and some who would not) for the past year.

As far as precious metals go, long-term, the gradual ratcheting up is likely to continue, as major entities and individuals diversify their wealth holdings into "non-dollar" areas. These parties will also consider credit blowoffs to be excellent buying opportunities.

[Spartacus]

Re: ‘Correlation’ rather than ‘contagion’

I had the opposite thought, Aaron.

The biggest markets are too big to be raised much by excess liquidity IF there's not a convincing-sounding fundamentals story (which Chinese markets have and the US not so much).

Emerging markets and many commodity markets are small enough that liquidity and Yen carry will raise them regardless of the story.

(all the above to be taken with much prevarication and hedging)

The analysis community is lacking a few basic tools that could really help make sense of the current situation.

Of glaring relevance here is some signals theory.

What appears to be going on here is that in the "high frequency band" (short term), all markets are correlated. Thus, as the stock markets crash, silver and gold crash (in fact even more precipitiously than the general market, judging by ETF shares).

I dunno, Aaron - let's see the FFTs and the Laplacians on those. ; )

[miju]

Re: ‘Correlation’ rather than ‘contagion’

Asron,
i like your definition and image of high and low frequency waves. to add some points in this definition : when high and low frequency converge (by contagion ) the noise of the frequency is becoming so inaudbible thant it becomes hard to make the distinction between them...
there is an asset class which has no correlation with low or high frequency and which is simple and useful when both waves get mixed : Cash !!!

[Rajiv]

Re: ‘Correlation’ rather than ‘contagion’

Listening to Bernanke yesterday was scary. Particularly when he was replying to questions by Marcy Kaptur. I think the Fed has decided that inflation is the way out! I think they are going to cut rates and increase the money supply! The new asset to inflate is "guess what?" It is "drumroll" The Stock Market!

The video of the hearing can be found here

[Finster]

Re: ‘Correlation’ rather than ‘contagion’

Neither "correlation" nor "contagion" really is adequate to explain what we've been seeing. That's because most of the movement this week is in only one asset class. Cash.

I've said it before and I'll say it again, because this one concept flummoxes even sophisticated commentators, as evidenced by the piece quoted at the top of this thread. Cash went up.

Why would we cast about for complex theories to explain some seemingly metaphysical connection between unrelated things, when one simple explanation will do? Occam's Razor: Cash went up.

Why would we acknowledge that cash is not a fixed reference point (e.g. we publish inflation stats, don't we?), and then when trying to explain the markets, act as if it were?

It really is that simple. Cash went up.

[Mish]

Re: ‘Correlation’ rather than ‘contagion’

In the context of Ka-Poom Theory, here at iTulip, we call the post 2004 period of positive asset correlation the All Assets Up phase of the post 2001 global central bank reflation "Poom." Expect an equally unusual All Assets Down "Ka" process to follow at some point, as global credit markets contract, starting with the canary in the coal mine, the sub-prime segment of the U.S. housing market.

Hmm
perhaps you need to change the theory to Poom-Ka ggg
Mish

[FRED]

Re: ‘Correlation’ rather than ‘contagion’

In the context of Ka-Poom Theory, here at iTulip, we call the post 2004 period of positive asset correlation the All Assets Up phase of the post 2001 global central bank reflation "Poom." Expect an equally unusual All Assets Down "Ka" process to follow at some point, as global credit markets contract, starting with the canary in the coal mine, the sub-prime segment of the U.S. housing market.

Hmm
perhaps you need to change the theory to Poom-Ka ggg
Mish

It's a cycle of asset inflation, crisis, asset deflation and money supply contraction, reflation (rate cuts, deficit spending, currency depreciation), asset inflation, money supply growth, etc. You do understand the concept of a cycle, right?

[akrowne]

Re: ‘Correlation’ rather than ‘contagion’

It really is that simple. Cash went up.

Finster, do you mean bonds or literally "dollars"?

Dollars (by the dollar index) cratered on the 27th, but came back a little bit later in the week. They're down since the initial shock.

http://finance.google.com/finance?q=RDPIX

If you mean bonds, those have done even worse:

http://finance.google.com/finance?q=IEI

[grapejelly]

Re: ‘Correlation’ rather than ‘contagion’

Finster, do you mean bonds or literally "dollars"?

Dollars (by the dollar index) cratered on the 27th, but came back a little bit later in the week. They're down since the initial shock.

http://finance.google.com/finance?q=RDPIX

If you mean bonds, those have done even worse:

http://finance.google.com/finance?q=IEI

The dollar may have fallen against other currencies, but all currencies taken together rose in price against most commodities (ex oil for instance), almost all stocks and almost all bonds.

The tell is that US treasurys went up in price. They are cash.

[Finster]

Re: ‘Correlation’ rather than ‘contagion’

Finster, do you mean bonds or literally "dollars"?

By "cash" in this context, I mean currency. In particular, the yen, and to a lesser degree, the dollar.

Dollars (by the dollar index) cratered on the 27th, but came back a little bit later in the week. They're down since the initial shock.

This explains the problem. GJ is correct. The "dollar index" you're looking at is probably the conventional one that merely pits one currency against another. The dollar is measured against the euro, yen, pound, etceteras. If those other currencies rose in market value and the dollar rose a bit less, it creates the false impression that the dollar fell.

[bart]

Re: ‘Correlation’ rather than ‘contagion’

If those other currencies rose in market value and the dollar rose a bit less, it creates the false impression that the dollar fell.

At the risk of muddying the waters more, here's a chart that has a parallel to what I think you're driving at. It's way too long term to show the current "cash gain" you're talking about, but the point is that there's a *huge* difference between CPI adjusted net worth and broad purchasing power value (as measured by the US broad dollar index).

It's similar to trying to judge cash gain by the very limited narrow dollar index - it's way too limited of a measuring stick (almost 60% of it is the Euro).

[Finster]

Re: ‘Correlation’ rather than ‘contagion’

At the risk of muddying the waters more, here's a chart that has a parallel to what I think you're driving at. It's way too long term to show the current "cash gain" you're talking about, but the point is that there's a *huge* difference between CPI adjusted net worth and broad purchasing power value (as measured by the US broad dollar index).

It's similar to trying to judge cash gain by the very limited narrow dollar index - it's way too limited of a measuring stick (almost 60% of it is the Euro).

Oy, but this is what the FDI attempts to address. ;)

When I talk about the market value of the dollar, usually I mean in the broadest sense. Not merely its value in terms of other currencies, nor in terms of the narrow measure of consumer goods and services, but what it is worth in global markets.

Looked at this way, the USD gained an incredible 2.04% in just this past week. Even more amazing was the JPY, which gained against the USD. In a sense, this was a currency rally in which cash as an asset class gained.

Just a guess, but from all appearances the prime mover was the yen, with the USD more or less being dragged along for the ride ...